Thank You

Error.

Shares of
Berkshire Hathaway
have beaten the market this year, and don't look especially cheap. However, investors looking to tap into the stock-picking prowess of its chief executive, Warren Buffett, should consider scooping up shares of some blue-chip Berkshire holdings that have recently lagged behind the market.

Year-to-date, Berkshire Hathaway (BRKA and BRKB) shares have gained 29%, trading recently at $173,000. That compares with a 26% gain for the Standard & Poor's 500. Berkshire holds cash, securities and wholly owned, independently managed companies. One way to track its prosperity is to watch the change in the accounting or "book" value of shares, tallied each quarter. This year through September, Berkshire's book value rose 11% to $126,766.

That puts shares at 136% of book value—above Buffett's own ceiling for using Berkshire's cash to repurchase and retire its shares. He originally limited repurchases to 110% of book value or less, but raised the limit to 120% last year. In other words, Berkshire looks fairly valued by Buffett's own standards.

One alternative is to buy shares of Berkshire holdings that have fallen behind. Investors who do so miss out on one of Berkshire's key advantages: the ability to make large, private investments by either buying companies in full or negotiating to buy special classes of securities with lucrative yields and privileges. But these investors also avoid two Berkshire headwinds. It's unlikely to match its own storied performance history from here, because it has grown so large that it must focus on giant investment targets. And Warren Buffett is 83. His eventual retirement could cost Berkshire shares some of their premium value.

Also, for investors looking for income, Berkshire pays no dividend. The following three companies each pay more than 2%.

ExxonMobil Up 11% year-to-date. ExxonMobil isn't one of Berkshire's recent underperformers. Rather, Berkshire last month reported a new stake in the company, likely attracted by the stock's subdued valuation. It has returned an average of just 6% a year over the past five years, versus 19% for the S&P 500. Shares go for less than 13 times this year's earnings forecast, versus 17 times for the index. What does Buffett see in Exxon shares that others don't? Perhaps the potential for sharply higher free cash flow.

Exxon has spent about $180 billion over the past five years on capital investments, but spending there should peak next year and decline thereafter, giving way to more free cash, according to Cowen & Co. analyst Asit Sen. Exxon shares pay a 2.7% dividend. Sen expects 10% yearly payment increases, and a total of 5% to 8% of the stock price to be returned to shareholders each year, including dividends and share repurchases.

International Business Machines Down 6% year-to-date. IBM shares are up only slightly from where Berkshire bought them in 2011, and have lost ground this year. In an October interview with Charlie Rose on PBS, Buffett reiterated his confidence in the company, pointing to its record earnings per share, even as revenues slip. IBM has been jettisoning low-margin hardware businesses and investing in higher-margin software ones.

IBM has also returned large sums of cash to shareholders. Since 2008, yearly free cash flow has totaled between $14 billion to $17 billion, and dividends plus share repurchases have ranged from 60% to 122% of free cash, according to Wells Fargo Securities. Shares sell for 11 times earnings and yield 2.1%.

Modi attributes the recent underperformance to temporary factors, including a cold, wet spring in North America; a restructuring of bottling operations there that caused a brief drop in volumes; and a sharp rise in ad spending by Pepsi. The current stock price treats these factors as permanent, implying just 2.3% yearly growth in earnings before interest and taxes through 2020, but growth should accelerate next year, and 6% yearly EBIT growth over the long term is more likely, according to Modi.